Should you use cash accounting? Or, accrual accounting in your business?
And, what’s the difference between these two popular methods of accounting?
These are questions that most eCommerce entrepreneurs have at some point.
The answer is it depends on the size of the business, the lens in which you are viewing your financials, and the level of reporting required. In this post, we’re going to discuss the pros and cons of both the cash method and accrual method in more detail.
What’s cash accounting?
Cash based accounting, a.k.a. cash basis accounting, is the method most sole proprietors, service businesses, and other small businesses without inventory use.
It’s simple to maintain, and there is no need to track accounts receivables or accounts payable. It mirrors the activity that you see across your bank and credit card statements.
With this system, you recognize the timing of transactions as soon as the cash leaves your account. And, you recognize revenue as soon as the cash is received.
It’s a real-time method of accounting that makes it easy to identify exactly when a transaction happened, and you can see at a glance how much money is in your business in a given time period.
What are the advantages of cash accounting?
Here are the key benefits of the cash basis method.
- It is simple – You are tracking cash inflows and outflows as they come in and out of your business. So, you don’t need to worry about complex accounting setups. Plus, you can apply many of the same principles you are already familiar with your personal accounting.
- It is present-focused – It is easy to see what your current bank balance and cash position is at any time.
- There are some tax benefits – While this mainly applies to service businesses instead of eCommerce brands, you can have more control over how to account for spikes in either revenue or expenses for tax purposes. For example, you might choose to lower your tax burden by making an expensive purchase in December instead of January.
While the simplicity of cash accounting might be enticing, it works better for service businesses. For example, since many eCommerce businesses have to pay for inventory and associated costs – sometimes months in advance of realized revenue – it makes sense to use accrual accounting to spread out these purchases to get a better sense over your business’s finances and overall profitability.
What’s accrual accounting?
If you choose to use accrual based accounting, revenues and expenses are recorded in your financial reporting when they are earned — not when the cash hits or leaves your account.
For example, this could be recognizing Amazon sales in full in December, whereas the cash accounting system would record the revenue sometime in January once you receive the payout.
The accrual accounting method is used more commonly by businesses who are growing and need a more robust picture of their financial patterns as it gives a more accurate long-term picture of the revenue and expenses a business incurs over time. It spreads annual costs – such as business insurance – out over the course of the year, which gives you a more accurate picture of the margins you are making on each sale.
What are the advantages of accrual accounting?
Here are the key benefits of the accrual cash basis method.
- Regularly have large expenses or inventory purchases – Almost all sizeable businesses with inventory will benefit from using accrual accounting. In fact, once you reach a certain threshold (i.e. $25M+ in the U.S), you are legally required to use accrual accounting.
- Receive sales spikes – If you receive a significant chunk of your revenue in bursts throughout the year as a wholesaler and providing credit terms, accrual accounting can work better. For example, if 70% of your revenue occurs during the holiday shopping season, you might want to use accrual accounting.
However, the major downside of accrual accounting is that it does not give you real awareness of your current cash flow. On paper, your business might look extremely successful, when in reality your bank accounts could be empty.
If you choose to use the accrual system, this also makes it easier to do proper cash flow forecasting, which allows you to plan for growth and model out different cash flow scenarios.
When should you switch from cash to accrual accounting?
Both methods can be done using cloud accounting software, like Xero.
However, the biggest difference between cash accounting and accrual accounting comes down to when sales and expenses are recorded in your financial statements.
Neither type of accounting is perfect, but it’s important to choose one and stick to it.
For brand new eCommerce businesses doing $100k or less in sales, it makes sense to stick with the simpler cash accounting method.
However, once your business is consistently doing six figures in annual revenue per year, you should consider switching to accrual accounting.
While accrual accounting takes more time and skill, it gives you a much more reliable set of financial data and a clearer financial picture on your business performance. It’s the better choice for businesses who are intending to expand and stay in the game for years to come.
Cash accounting is easy to manage and is probably a better choice for businesses who plan to stay small or who have limited transactions over the course of each year.
Looking for expert advice on which accounting method to use? Schedule a free call with a Bean Ninjas team member.